Callaway Lands in the Rough

September 15, 2004

Shareholders of Callaway Golf (ELY) might not want to look at its scorecard for Sept. 15.ellers sliced 13% from the share price following the previous evening's announcement by the maker of Big Bertha clubs and Top-Flite Balls that it's suspending quarterly and annual earnings guidance.

The reason? Callaway cited "several unknowns" in a press release, including the status of customer reorders for the rest of the year and the timing of new product launches, either of which could crimp sales and earnings for 2004 "to levels significantly below those that were predicted earlier."

AT A CROSSROADS. Specifically, Callaway doesn't expect to achieve its earlier guidance estimates of between $975 million and $990 million in net sales and 15 cents to 25 cents in earnings per share for 2004, including estimated integration charges of about 25 cents per share. It also no longer expects to reach its previous guidance for the third quarter of approximately $150 million to $160 million in net sales and net losses of 37 cents to 42 cents per share.

Callaway, once a Wall Street darling, has struggled in recent years amid a stagnant golf market and increasing competition. And it appears to have reached a crossroads: As new CEO William Baker takes the helm, the company wants to "fully review" its business.

Jason Asaeda, an analyst for Standard & Poor's Equity Research Services, remains negative on the stock, assigning it an S&P ranking of 2 STARS (avoid). Asaeda corresponded by e-mail with BusinessWeek Online's William Andrews about Callaway's difficulties and his current view of the stock. Here are edited excerpts of their exchange:

Note: Jason Asaeda is a Standard & Poor's Equity Analyst. He has no ownership interest in or affiliation with Callaway Golf.

Q: You already had a negative outlook on the stock, but the Street clearly didn't foresee the scope of Callaway's problems. Were you surprised?

A: I was surprised by the tone of the announcement. It leaves a lot of questions open-ended and certainly limits near-term earnings visibility.

A: S&P's avoid recommendation is based on valuation, as well as our view of Callaway's weak industry positioning and poor operating history.There are no quick fixes for the problems, andwe see turnaround initiatives taking time to gain traction.

Given likely sales impact from the absence of new products until 2005, as well as potential increases in markdowns to drive existing product sales, wecut our2004 and 2005 EPS estimates (which exclude one-time charges) each by 10 cents, to 30 cents and 70 cents, respectively. Our 12-month target price of $10 is based on a blend of our p-e and

discounted cash-flow analyses.

Q: Callaway made a big move by buying the Top-Flite ball business. How is that deal working out?

A: Callaway lastprojected losses at Top-Flite would be between 10 cents to 14 cents a share in 2004 (including estimated integration charges of about 25 cents). The losses reflect the company's efforts to reduce excess retail inventory of Top-Flite balls in advance of next year's golf season.

Callaway has reported that the integration between Top-Flite and Callaway Golf is progressing well. It hasshifted most of its golf-ballproduction to Top-Flite to improvemanufacturing efficiencies,and management expects recent restructuring of both businesses toresult inannual savings of nearly $9 million in 2005.Next steps include the integration of information systems to a common platform.

A: The Big Bertha business has been hurt by intense price discounting by competitors as well as by Callaway's slow response to changing customer preferences and demands.As a result, thecompanyhas been forced totrade off gross profit dollarsfor incremental sales with its lower pricing. We think this strategy may be eroding Big Bertha's premium-brand equity.

Q: Callaway's new CEO is taking the reins at a particularly rough time. What can he do to address the major problems?

A: The company redefined golf clubs with Big Bertha, but over time,dropped the ball. Baker's challenge is to get Callawayto deliverthe right products to its customers on a more timely basis though market research and technology investments.